WES - Natural Gas Demand Is Soaring: Earn +8% Yields From Western Midstream

2023-12-26 07:35:00 ET

Summary

• Recognize that the natural gas surplus is only one side of the equation; assessing capacity relative to demand is crucial.
• Western Midstream is actively fortifying its asset portfolio and enhancing shareholder returns through distribution raises and share buybacks.
• Despite industry-low debt levels and higher yields, WES is considered considerably undervalued.
• Collect +8% dividends to await operational improvements and acquisitions to translate into earnings.

Co-authored with "Long Player"

Projections for the warmest autumn in the Northern Hemisphere in nearly 150 years have pushed natural gas prices lower at the start of winter. In addition, record-high U.S. production, record-high inventories, weak industrial demand in Europe, and fuller storage sites in Asia have also weighed their effect on the price.

Wall Street is obsessed with natural gas storage surplus, without giving emphasis to the growth in demand and the lack of correlated growth in storage capacity. Lack of storage capacity relative to demand, limited coal switching ability, and renewable intermittency will amplify price volatility. Source

The fact is that even if that warm El Niño winter arrives as predicted, natural gas storage has a long way to go to get to probably what it should be to avoid "crunch times".

Eventually, that will happen. It may well be worth waiting for that to happen because getting storage to adequate levels rather than relying on "just in time" deliveries will save money through reduced supply disruptions. Usually, it takes a major event before anyone challenges the status quo. But the graph above shows the lack of preparedness to handle a soon-approaching major event.

Introducing Western Midstream

When Occidental Petroleum ( OXY ) acquired Anadarko , it also acquired Western Midstream Partners, LP ( WES ), but the latter operates as a standalone business . WES owns and operates 24 gathering systems, 75 processing and treatment facilities, 7 natural gas pipelines, 15 crude oil / NGL pipelines, and 16,000 miles of pipeline assets, making them a key player in the Delaware Basin in West Texas and New Mexico and the DJ Basin in northeastern Colorado. Source

Note: WES issues a Schedule K-1 to investors.

Recently, Western Midstream announced the acquisition of Meritage Midstream for $885 million. The transaction has closed, and the company made a quarterly dividend increase to $0.575/share.

Western Midstream is part of the Anadarko operation that enhanced Occidental's position in the Colorado area. Anadarko had a particularly strong presence in this area that Occidental did not have. This is a rapidly growing basin due to the excellent cost structure. It readily competes with more established basins like the Permian without that acreage cost because it is not yet "the place to be". The result is that both Colorado and Wyoming are experiencing decent production growth.

Naturally, with this growth comes some transportation needs, and midstream turns out to be an Occidental specialty as the company has long grown and sold midstream capacity while making decent profits. Occidental typically operates midstream capacity as a buy-and-hold strategy while opportunistically selling some assets during upstream business cycle peaks when prices are likely to climb "out-of-sight". This often results in some large but irregular gains for shareholders.

The last time, Occidental sold a significant midstream worth $2.6 billion to different parties. Investors can expect Occidental to wait for transportation shortages before again selling some midstream properties.

Acquisition Benefits

The Meritage acquisition is the equivalent of a "bolt-on" acquisition. There are going to be a lot of connections that will enhance customer service by way of increasing transportation flexibility. On the other side of the coin, Occidental will have a lot more volume to bargain with when hooking up to pipelines that can get the production to various markets.

The result of this is that the two systems together are going to do a lot more business than they were separately. This is likely to result in a lot more dividend increases after the one that happens when the deal closes.

The other positive is that most of the acquired customers are investment grade. That customer mix could become more investment grade over time as larger companies acquire smaller players that were first into this basin. All that does is improve the reliability of payments and decrease bad debt expenses in the future.

Since this is one of the more profitable basins in North America, Occidental will likely emphasize some growth in operations in this area, and Wyoming is extremely supportive of the oil and gas industry. Also, keep in mind that Occidental is very good at safely operating this equipment at more than the original nameplate capacity. This will take some time, but investors can expect the combined midstream operation to handle greater volumes and generate bigger profits.

Pipelines have a lot of operational leverage because they are often built considerably larger than the outstanding commitments in developing areas. Therefore, filling up capacity and debottlenecking projects are relatively cheap with very fast paybacks. The midstream business does have relatively long contracts with minimum take-or-pay provisions that protect earnings from downturns. Those provisions probably will not be necessary in a growing basin like this one, but it is still nice to have.

Returns to shareholders

WES' dividend yield stands at 8.3% and is growing rapidly, and the company repurchased 5.1 million of common units from Occidental for $127.5 million. The partnership's TTM base distribution carries a 77% FCF payout ratio.

The company's recent acquisition also jump-starts the process of filling the pipeline assets it already has. Therefore, investors should expect steady dividend increases above industry-average rates.

WES maintains investment grade ratings, giving the company access to debt at a lower cost than those same competitors at a time of higher interest rates.

Valuation

Similarly, adjusted EBITDA passed $500 million, and the company projects the figure to be ~$2 billion for FY 2023. The recently closed acquisition is likely to add to that, as is the announcement of more dedicated acreage. There is, in addition, roughly $7 billion in debt, reflecting a 3.4x ratio. This is one of the lowest midstream debt ratios among investment-grade midstream companies.

With an enterprise value of ~$18 billion, WES' EV-to-EBITDA ratio stands at about 9x, which is among the lowest among companies with a sizable midstream operation.

Accretion from the recent acquisition, along with continued operational improvements made by Occidental, would bring WES' valuation to roughly 11-13x. With that, the company's dividend yield should revert to the 5-6% range through significant stock price appreciation.

Conclusion

Despite reports of record U.S. natural gas inventories, Wall Street is ignoring the fact that demand is also at record levels. The reality is that the current gas capacity, in relation to demand, is nearing all-time lows, emphasizing the need for robust midstream infrastructure to ensure accessible supply.

WES' substantial 8.3% yield and cheap valuation present a compelling bargain to participate in the turnaround story directed by Buffett-backed OXY. Not only is this issue suitable for risk-averse and income investors, but it is also suitable for growth investors as the turnaround proceeds. This is a bargain that is very unlikely to last.

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